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Introduction The Model Empirical Analysis

Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Alessia Isopi1 Fabrizio Mattesini2

1University of Nottingham, UK 2University of Rome Tor Vergata, Italy

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis

Outline

Introduction Motivation Existing Literature Purpose of the Paper The Model Set up

The Players

Solving the Model The Maximization Programs Equilibrium Contracts Theoretical Results Empirical Analysis Main Results

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Motivation

Stylized Facts

◮ The Corruption Perception Index (2006) shows that almost

3/4 of developing countries experience a very high level of corruption;

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Motivation

Stylized Facts

◮ The Corruption Perception Index (2006) shows that almost

3/4 of developing countries experience a very high level of corruption;

◮ Corruption not only affects the process of economic growth,

but also encourage people to apply their skills and energies in non productive ways (Mauro,(1995)).;

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Motivation

Stylized Facts

◮ The Corruption Perception Index (2006) shows that almost

3/4 of developing countries experience a very high level of corruption;

◮ Corruption not only affects the process of economic growth,

but also encourage people to apply their skills and energies in non productive ways (Mauro,(1995)).;

◮ Corruption reduces also aid effectiveness both directly by

diverting a percentage of aid from intended purposes or indirectly by promoting inappropriate uses of aid (See Cooksey (2003);

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Motivation

Stylized Facts

◮ The Corruption Perception Index (2006) shows that almost

3/4 of developing countries experience a very high level of corruption;

◮ Corruption not only affects the process of economic growth,

but also encourage people to apply their skills and energies in non productive ways (Mauro,(1995)).;

◮ Corruption reduces also aid effectiveness both directly by

diverting a percentage of aid from intended purposes or indirectly by promoting inappropriate uses of aid (See Cooksey (2003);

◮ Do actually bilateral donors take the problem of

corruption into account in their development policies?

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Literature

Existing Literature

◮ Alesina and Weder (2002) show that for most donors

corruption is not a significant explanatory variable in bilateral aid allocation and conclude that there is no evidence that less corrupt governments receive more foreign aid.

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Purpose of the Paper

Purpose of the Paper

The purpose of this paper is twofold:

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Purpose of the Paper

Purpose of the Paper

The purpose of this paper is twofold:

• 1. We provide new empirical evidence on the relationship

between aid and corruption and on its changes over time;

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Purpose of the Paper

Purpose of the Paper

The purpose of this paper is twofold:

• 1. We provide new empirical evidence on the relationship

between aid and corruption and on its changes over time;

• 2. Using a static principal-agent model of aid allocation, we

provide a structural interpretation of this evidence, focusing

• n the role played by donors’ preferences and recipients’

incentives;

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Purpose of the Paper

Purpose of the Paper

The purpose of this paper is twofold:

• 1. We provide new empirical evidence on the relationship

between aid and corruption and on its changes over time;

• 2. Using a static principal-agent model of aid allocation, we

provide a structural interpretation of this evidence, focusing

• n the role played by donors’ preferences and recipients’

incentives;

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Set up

Environment

We analyze an optimal aid allocation procedure in an environment where:

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Set up

Environment

We analyze an optimal aid allocation procedure in an environment where:

◮ i) Donor beside the goal of helping the poor may also be

conditioned by non altruistic motives;

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Set up

Environment

We analyze an optimal aid allocation procedure in an environment where:

◮ i) Donor beside the goal of helping the poor may also be

conditioned by non altruistic motives;

◮ ii) Inefficiencies arise in the implementation of aid projects due

to asymmetric information and moral hazard;

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Set up

The Recipient Country: Type I agents

Type I agents, (the elite), owns the technology necessary to influence the outcome of the project; ue

0 = (γ + b)[π0θf (a) + (1 − π0)θf (a)]

(1) if they undertake the bad action and ue

1 = γ[π1θf (a) + (1 − π1)θf (a)] − ψ

(2) if they undertake the good action. Note that π1 > π0.

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Set up

The Recipient Country: Type II agents

Type II agents,(the poor), cannot influence the realization of the project. up

0 = (1 − γ − b)[π0θf (a) + (1 − π0)θf (a)]

(3) if type I agents undertake the bad action and up

1 = (1 − γ)[π1θf (a) + (1 − π1)θf (a)]

(4) if type I agents undertake the good action.

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Set up

The Donor Country

Vd = E[λue + (1 − λ)up] − C(a) (5) where C(a) = δa (6)

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Solving the Model

Optimizing Choice

The parameters of the model identify two possible optimizing behaviors:

◮ The donor can and/or wants inducing type I agents to

undertake the high level of effort. In this case, we can distinguish between:

◮ a case where moral hazard is not a relevant issue; ◮ or a case where, being moral hazard relevant, the donor

induces type I agents to undertake the high level of effort.

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Solving the Model

Optimizing Choice

◮ The donor cannot and/or does not want to inducing type I

agents to undertake the high level of effort. In this case, we can have:

◮ donors allow local elites to capture a large part of the aid flows

for strategic or economic reasons;

◮ being donors concerned on the welfare of the poor, when they

realize that aid transfers will never reach people in need, they might be better off denying funding to that particular recipient.

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis The Maximization Programs

The Maximization Program n.1

If:

• [λγ + (1 − λ)(1 − γ)](Φ1 − Φ0) + Φ0(1 − 2λ)b
• f (a) ≥ λγψ (7)

holds, the maximization problem is given by:

max

a

Φ1[λγ + (1 − λ)(1 − γ)]f (a) − δa (8) sub Φ1γf (a) − Φ0

• (γ + b)
• f (a) − ψ ≥ 0

(9) Φ1γf (a) − ψ ≥ 0 (10) a ≥ 0 (11) where equation (8) is the objective function of the donor, (9) represents the incentive compatibility constraint, equation (10) the individual rationality constraint and equation (11) is the non negativity constraint on a.

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis The Maximization Programs

The Maximization Program n.2

If:

• [λγ + (1 − λ)(1 − γ)](Φ1 − Φ0) + Φ0(1 − 2λ)b
• f (a) < λγψ

and

• (Φ1 − Φ0)γ − Φ0b
• < 0

(12) the maximization problem is given by:

max

a

Φ0

• λ(γ + b) + (1 − λ)(1 − γ − b)
• f (a) − δa

(13) a ≥ 0 (14)

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Equilibrium Contracts

Optimal Foreign Aid Contracts

When type I agents undertake i = 1, we get:

• 1. Equilibrium 1 where the optimal level of aid is given by:

f ′(a∗)Φ1F(γ, λ) = δ (15)

• 2. and Equilibrium 2, where:

B(γ, b)f (a∗) = ψ (16) When type I agents undertake i = 0, we get:

• 3. Equilibrium 3, where the optimal level of aid is equal to:

f ′(a∗)Φ0 [F(γ, λ) − (1 − 2λ)b] = δ (17)

• 4. and Equilibrium 4, given by:

a∗ = 0 (18)

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Theoretical Results

Results

• 1. The first equilibrium identifies a level of aid always incentive compatible,

i.e. at this level of aid local elites do not have any incentive to undertake the low level of effort and capture private benefits;

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Theoretical Results

Results

• 1. The first equilibrium identifies a level of aid always incentive compatible,

i.e. at this level of aid local elites do not have any incentive to undertake the low level of effort and capture private benefits;

• 2. In the second equilibrium the donor uses aid contracts to induce type I

agents to undertake the high level of effort. The level of aid is not influenced by a donor’s preferences but is increasing in the level of effort ψ and decreasing in the composite parameter B(γ, b);

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Theoretical Results

Results

• 1. The first equilibrium identifies a level of aid always incentive compatible,

i.e. at this level of aid local elites do not have any incentive to undertake the low level of effort and capture private benefits;

• 2. In the second equilibrium the donor uses aid contracts to induce type I

agents to undertake the high level of effort. The level of aid is not influenced by a donor’s preferences but is increasing in the level of effort ψ and decreasing in the composite parameter B(γ, b);

• 3. The third equilibrium occurs when there is no level of aid that

guarantees incentive compatibility and the donor derives a higher utility from type I agent exerting i = 0;

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Theoretical Results

Results

• 1. The first equilibrium identifies a level of aid always incentive compatible,

i.e. at this level of aid local elites do not have any incentive to undertake the low level of effort and capture private benefits;

• 2. In the second equilibrium the donor uses aid contracts to induce type I

agents to undertake the high level of effort. The level of aid is not influenced by a donor’s preferences but is increasing in the level of effort ψ and decreasing in the composite parameter B(γ, b);

• 3. The third equilibrium occurs when there is no level of aid that

guarantees incentive compatibility and the donor derives a higher utility from type I agent exerting i = 0;

• 4. Also in the forth equilibrium there is not a level of aid that induce type I

agents to exert i = 1, but, in this case, the donor is mainly concerned about the welfare of the poor, and therefore optimality requires no aid.

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Theoretical Results

Testable Implications

Our results imply:

• 1. if donor does not perceive the existence of a meaningful moral hazard

problem and does not impose any incentive constraint, aid and corruption should not be correlated;

• 2. if we find instead that there exists a +ve relationship between corruption

and aid, the optimal level of aid could be given either by the second equilibrium or by the third equilibrium of the model when λ > 1/2;

• 3. a -ve relationship between aid and corruption is instead obtained in the

third equilibrium of our model when λ < 1/2, i.e. when donors are very interested in the welfare of the poor.

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis

Strategy

• 1. We regress the Aid/GDP ratio, for each donor, on a series of

explanatory variables that describe the main institutional and economic features of the recipients;

• 2. Our sample covers 168 recipients and 14 donors, members
• f the Development Assistance Committee (DAC) of the

OECD, spanning the period 1985-2006;

• 3. The estimation method we use is the Tobit model, which

takes into account that the dependent variable is left censored.

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis

Empirical Model

For every donor and for the three periods (1985-1995; 1996-2006; 1985-2006), we estimate two different equations:

• 1. A first specification similar to the one provided by Alesina and Weder,

where we add Budget Deficit and Military Expenditure: AidCommitments/GDP = α0 + β1GDPpercapita + β2Population+ β3Democracy + β4Corruption + β5Trade + β6Colony

• 2. A second specification where we drop the variable Military Expenditure

that significantly reduces the number of observations;

• 3. In every equation estimated for USA, we add three dummies (Israel,

Egypt and USA Protectorate) and the variable UN in order to capture specific strategic interest.

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis

Empirical Results

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis

Empirical Results

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis

Empirical Results

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis

Empirical Results

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis

Empirical Results

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis

Empirical Results

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis

Empirical Results

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis

Empirical Results

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Main Results

Main Results

◮ The majority of the donors tends to prefer recipients with a

low level of the GDP per capita and a high degree of democracy;

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Main Results

Main Results

◮ The majority of the donors tends to prefer recipients with a

low level of the GDP per capita and a high degree of democracy;

◮ Bilateral trade between the donor and the recipients positively

affects aid allocation, especially for those donors that use to have colonies;

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Main Results

Main Results

◮ The majority of the donors tends to prefer recipients with a

low level of the GDP per capita and a high degree of democracy;

◮ Bilateral trade between the donor and the recipients positively

affects aid allocation, especially for those donors that use to have colonies;

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Main Results

Main Results

◮ Scandinavian countries (Denmark, Finland, Norway and

Sweden) tend to give more aid, ceteris paribus, to less corrupt countries (Equilibrium 4);

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Main Results

Main Results

◮ Scandinavian countries (Denmark, Finland, Norway and

Sweden) tend to give more aid, ceteris paribus, to less corrupt countries (Equilibrium 4);

◮ There are donors that do not perceive corruption as a relevant

problem in their aid allocation decisions and set the level of aid mainly on the basis of their costs/benefits analysis (UK, Australia and the Netherlands) (Equilibrium 1);

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?

Introduction The Model Empirical Analysis Main Results

Main Results

◮ Scandinavian countries (Denmark, Finland, Norway and

Sweden) tend to give more aid, ceteris paribus, to less corrupt countries (Equilibrium 4);

◮ There are donors that do not perceive corruption as a relevant

problem in their aid allocation decisions and set the level of aid mainly on the basis of their costs/benefits analysis (UK, Australia and the Netherlands) (Equilibrium 1);

◮ There is, finally, a third group of countries (USA, Italy, France,

Spain and Canada) that, although for the last three donors the level significance is much lower, appear to grant more aid, ceteris paribus, to more corrupt recipients (Equilibrium 2 or 3);

• A. Isopi and F. Mattesini

Isopi and others Aid and Corruption: Do Donors Use Development Assistance to Provide the Right Incentives?